In this most convulsive and confusing time in modern American finance, one point stands out: Credit market failure has pushed the economy to the edge, and policymakers are scrambling to pull it back. When investors began to flee the heretofore safe harbor of money-market funds in favor of Treasury bills that guaranteed a mere 0.04% return, it was plain that confidence in the financial system was breaking down. The government's ad hoc approach, intended to prevent failing institutions from collapsing the system, was not working. Now, amid Depression-era analogies, Washington is assembling a $700 billion plan to shore up the markets and rescue the economy.
The bad news is, regardless of the plan's passage, the economy is still a mess, and the near-term downdrafts on growth have become stronger. Credit conditions will grow even tighter for a while as investors hunker down and flee risky assets. Banks remain hesitant to lend to one another, and corporations—even AAA-rated companies—are having new difficulties raising funds. Fear and uncertainty will further undermine confidence and depress spending. Companies will put capital projects and hiring plans on hold, assuring labor markets will weaken further. Household wealth also will continue to decline, as it has done for the past three quarters. Meanwhile, some overseas economies, a major engine for U.S. growth, are headed for a recession.
On the plus side, by slashing the risk of a financial meltdown, the government's massive effort should restore confidence and put the economy on track for at least a modest recovery later next year—not two or three years from now. The mega-bailout addresses the economy's core problem: the corrosive cycle set in motion by the housing slump. The cycle starts with falling house prices and mortgage defaults. That destroys the liquidity of mortgage-related securities and causes banks to restrict credit to home buyers and other borrowers. In turn, this credit crunch cuts even deeper into home demand, further depressing prices and poisoning more securities as the cancer spreads.
The plan is designed to halt this cycle. Purchases of distressed mortgages and other illiquid securities will bolster bank balance sheets, easing restrictions on credit. Also, with Fannie Mae (FNM) and Freddie Mac (FRE) set to increase their purchases of prime mortgages greatly, mortgage rates should slip lower. All this will add support to home demand and prices by next year.
Meanwhile, investors are zeroing in on the potential cost of the bailout, especially its impact on the federal budget and the consequences of the coming surge in new issues of Treasury securities. The weak economy and the takeovers of Fannie Mae, Freddie Mac, and American International Group (AIG), along with the additional funds supplied to the Federal Reserve, had already pushed estimates of Treasury's fiscal 2009 deficit to some $700 billion. Now comes the $700 billion needed to purchase troubled assets.
One fear is that foreigners, who own just over half of all Treasuries, will balk at supplying the new funds. That fear has caused a sharp reversal in the dollar's recent rebound. Treasury debt should remain attractive, however, especially given the improving outlook for inflation, and the pluses to the economy from the bailout plan will eventually buoy the greenback.
Another worry is that such massive government borrowing could crowd out private investment and push interest rates up. This argument seems weak as well. Given prospects for only a modest recovery, private-sector credit demand is unlikely to show much bounce anytime soon, and more frugal consumers will most likely be adding to the pool of private savings.
Make no mistake, based on funds already committed and those likely to be, the cost of this bailout is huge, some 7% of gross domestic product. The important point, however, is this: The cost of not doing the bailout, in lost output, jobs, income, and profits, would be much, much greater.